Sortino ratio: A better measure of risk

In many ways, the Sortino ratio is a better choice, especially when measuring and comparing the performance of managers whose programs exhibit positive skew in their return distributions. The Sortino ratio is a modification of the Sharpe ratio, using downside deviation rather than standard deviation as the measure of risk — i.e., only those returns falling below a user-specified target (“Desired Target Return”) or required rate of return are considered risky (see “Good news, bad news”).

It is interesting to note that even Nobel laureate Harry Markowitz, when he developed Modern Portfolio Theory (MPT) in 1959, recognized that because only downside deviation is relevant to investors, using it to measure risk would be more appropriate than using standard deviation. However, he used variance (the square of standard deviation) in his MPT work because optimizations using downside deviation were computationally impractical at the time.

In the early 1980s, Dr. Frank Sortino had undertaken research to come up with an improved measure for risk-adjusted returns. According to Sortino, it was Brian Rom’s idea at Investment Technologies to call the new measure the Sortino ratio. The first reference to the ratio was in Financial Executive Magazine (August 1980) and the first calculation was published in a series of articles in the Journal of Risk Management (September 1981).